Standard Oil Co.
v.
Comm'r of Internal Revenue

United States Tax CourtMay 27, 1970
54 T.C. 1099 (U.S.T.C. 1970)
54 T.C. 1099T.C.

Docket No. 3613-68.

1970-05-27

STANDARD OIL COMPANY (INDIANA), PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Lee I. Park and Glenn L. Archer, Jr., for the petitioners. J. C. Linge, for the respondent.


Lee I. Park and Glenn L. Archer, Jr., for the petitioners. J. C. Linge, for the respondent.

In 1955 T assigned gas rights in certain oil and gas leases in return for annual payments based on the volume of actual or possible gas production. Apart from a cash payment for physical equipment and facilities, T received no present consideration and looked solely to the deferred annual payments in respect of gas production or potential gas production as consideration for the gas reserves themselves. No limit was placed on the amount of such payments, and the assignee was not permitted to sell any of the assigned gas rights without the consent of T. In 1958 the parties modified the instruments under which the assignments had been made by setting a $134,619,000 limit on the amount of the deferred payments owed by the assignee and by permitting the assignee to sell the gas rights without obtaining T's consent, provided that T would be entitled to one-half of the proceeds of such sale. At the time the modifications were made, a reasonable estimate of the time required to pay the total consideration, in view of the variables involved, would have been between 50 and 100 years; the assignee was not required to pay interest on the unpaid balance. Held: As a practical matter in the circumstances of this case, T looked solely to gas production as the source of the deferred payments and consequently retained an ‘economic interest’ in the gas properties in question. Deferred payments received in 1958 and 1959 therefore represent ordinary income to T rather than the proceeds of sale of a capital asset.

The Commissioner determined deficiencies of $261,786.85 and $395,085.70 in the consolidated income tax of petitioner and its affiliated corporations for the calendar years 1958 and 1959, respectively. The only issue remaining for decision involves payments made in 1958 and 1959 by Pacific Northwest Pipeline Corp. to Pan American Petroleum Corp., one of petitioner's subsidiaries. The question presented is whether the payments represented part of the sale price of interests in certain oil and gas leases and therefore reflect long-term capital gain to Pan American, or whether, on the other hand, the payments were made in respect to Pan American's retained interest in the leases and therefore constitute ordinary income to Pan American.

FINDINGS OF FACT

The parties have stipulated certain facts, which, together with the attached exhibits, are incorporated herein by this reference.

Petitioner, Standard Oil Co. (Ind.), hereinafter referred to as Standard, is a corporation organized under the laws of the State of Indiana. Its principal place of business and principal office is located at 910 South Michigan Avenue, Chicago, Ill. Standard, as the parent corporation, and affiliated companies filed consolidated returns for the calendar years 1958 and 1959 with the district director of internal revenue, Chicago, Ill. At all times material, the books of Standard and its affiliated companies were maintained on an accrual basis.

At all times herein relevant, Standard and its affiliates were engaged in the business of acquiring, exploring, and developing oil and gas properties, and producing, refining, and marketing petroleum and petroleum products.

Pan American Petroleum Corp., formerly known as Stanolind Oil & Gas Co. and hereinafter sometimes referred to as Pan American or Stanolind, is a wholly owned subsidiary of Standard and filed consolidated returns with Standard for the taxable years 1958 and 1959. Prior to March 15, 1955, Pan American acquired certain oil and gas leases in an area in New Mexico and Colorado commonly known as the San Juan Basin. It had been generally known for some time that the Basin included a number of different formations and structures which might be productive oil and/or gas. The Basin encompassed separate subareas which were identified by their individual names. The leases were located in the subareas known as the Bondad area (La Plata County, Colo.), the Township Units area (Rio Arriba County, N. Mex.), the Rosa Unit area (Rio Arriba and San Juan Counties, N. Mex.), the Ignacio area (La Plata County, Colo.), the N.W. Cedar Hill (South Bondad) area (La Plata County, Colo.), the Huerfano area (San Juan County, N. Mex.), the North Rosa area (Rio Arriba and San Juan Counties, N. Mex.), and the Arboles area (La Plata and Archuleta Counties, Colo.). Typically, a lease remained in effect for a term of years or so long thereafter as oil or gas was, or in some cases could be, produced. Each lease ordinarily required a 12 1/2-percent royalty on the production under the lease or on the proceeds from the sale of the oil or gas produced; in some cases, a small initial cash payment or a nominal minimum annual royalty was also required.

On March 16, 1955, Pan American transferred certain interests in its San Juan Basin leases to Pacific Northwest Pipeline Corp. (Pacific). Pacific was a natural gas pipeline company, producing, transporting, and selling natural gas. It was formed sometime prior to 1955 for the purpose of obtaining a certificate from the Federal Power Commission (FPC) authorizing it to construct and operate a pipeline from the four-corners area of Colorado, New Mexico, Utah, and Arizona— where the San Juan Basin was located— to the Canadian border, north of Seattle, Wash. But before Pacific could receive authority to operate the pipeline, it had to satisfy the FPC's gas supply requirement. The proposed pipeline was to take part of its supply from the San Juan Basin, and in entering the transaction with Pan American, Pacific was interested in securing gas rights only. Although Pan American was engaged to a certain extent in the production and sale of gas in addition to its petroleum business, it was not interested in continuing to exploit the gas reserves in the San Juan Basin properties covered by the foregoing leases, notwithstanding that it had already expended $1,422,227.62 for equipment, facilities, and productive gas wells in respect of such properties. Pan American was primarily interested in oil, and the March 16, 1955, transaction was designed in such manner as to reserve to Pan American any oil of consequence that might be within the leased properties.

In order to effectuate the transaction, Pan American and Pacific entered into eight contracts specifying their rights and obligations with respect to the leases. Only six of the contracts (relating to an aggregate of some 564 leases) are involved in this proceeding; Pan American received no payments attributable to the other two contracts during the years in question. Each contract was designated as a ‘Sales Contract and Operating Agreement’ and governed the leases in one of the subareas named above. The interests assigned to Pacific were limited to certain geological formation (the Pacific formations), each of which was though to be gasbearing only. Oil and gas rights in the remaining formations were retained by Pan American. Each formation represents a different geologic layer or subsurface stratum of the earth and is identified by a characteristic name. The formations in which Pacific was assigned interests were, in descending order from the surface, the Pictured Cliffs (Fruitland-Pictured Cliffs in Colorado), the Mesa Verde, and the Dakota, all of which were above the Morrison formation. The contract numbers for the six contracts involved herein and the subareas and formations governed by each contract were as follows:

+---------------------------------------------------------+ ¦Contract ¦ ¦ ¦ +----------+---------+------------------------------------¦ ¦No. ¦Subarea ¦Formations ¦ +----------+---------+------------------------------------¦ ¦27836 ¦Bondad ¦All formations above the base of the¦ +---------------------------------------------------------+

Morrison formation. 27834 Township Units All formations above the base of the Mesa

Verde formation. 27833 Rosa Unit All formations above the base of the Mesa

Verde formation. 27832 Ignacio All formations below the base of the Pictured

Cliffs formation and above the base of the Morrison formation. 27831 Northwest Cedar Hill All formations above the base of the Mesa (South Bondad) Verde formation. 27829 Huerfano All formations above the base of the Pictured

Cliffs formation.

After reciting that Pan American (Stanolind) had ‘conveyed and assigned’ certain oil and gas leases to Pacific, each contract went on to state that such conveyances and assignments were subject, inter alia, to the terms of such contract, which governed the ‘interdependent rights and obligations of the parties with respect to the maintenance, development, operation, payment for the rights conveyed, and release or reassignment of the leases.’

Relevant provisions of the contract which followed may be summarized as follows: Pan American agreed to transfer to Pacific, in return for an amount equal to its cost, its interest in lease equipment, facilities, and productive wells on the property covered by the assigned leases; payment for such physical equipment, facilities, and productive wells was to be made in full contemporaneously with the execution of the contract by certified or cashier's check. Pacific agreed to develop the assigned oil and gas rights at least as rapidly as it developed other properties in the area which had been assigned to it by other parties. (Pacific acquired substantial gas reserves in the San Juan Basin from parties other than Pan American.) In any event, Pacific was required to develop at least 25 percent of the net acreage within 2 years from the date of assignment, 75 percent within 4 years, and 100 percent within 7 years. In the event that Pacific failed to fulfill its continuing obligations under the contract, Pacific was obligated to reassign the leases to Pan American. It was also provided that Pacific would release or reassign to Pan American all or a portion of its rights in any of the leases once Pacific determined that it could not economically develop those rights. Furthermore, if, within 2 years of such reassignment, Pan American completed a gas well in a formation which had previously been assigned to Pacific, Pan American had the option to assign back to Pacific the reassigned acreage and to be reimbursed for its drilling expenses. The contract also provided that, under certain conditions and subject to provisions for reimbursement for costs,

if Pacific has any well which it intends to plug and abandon but which could be drilled deeper to a * * * (Pan American) formation, or if (Pan American) * * * has any deeper well which it intends to plug and abandon but which Pacific could plug back and complete in a Pacific formation, the party owning the well shall notify the other party of its intent to abandon and the party receiving such notice may, as its election, take over such well.

Pacific agreed to pay Pan American amounts based on ‘the volume of gas produced and attributable to (Pan American's) * * * working interest assigned to Pacific's as follows:

Minimum rates:

+-----------------------------------------------------------------------------+ ¦ ¦Amount per thousand ¦ +---------------------------------------------------+-------------------------¦ ¦Period ¦cubic feet (MCF) ¦ +---------------------------------------------------+-------------------------¦ ¦ ¦ ¦ +-----------------------------------------------------------------------------¦ ¦For the first 2 years from initial delivery into the pipeline to be ¦ ¦constructed ¦ +-----------------------------------------------------------------------------¦ ¦by Pacific or from July 1, 1956, if earlier ¦$0.07 ¦ +---------------------------------------------------+-------------------------¦ ¦For the following 8 years ¦0.08 ¦ +---------------------------------------------------+-------------------------¦ ¦For the following year ¦0.09 ¦ +---------------------------------------------------+-------------------------¦ ¦For the following 9 years ¦0.10 ¦ +---------------------------------------------------+-------------------------¦ ¦For the following 5 years ¦0.11 ¦ +-----------------------------------------------------------------------------+

For each subsequent 5-year period thereafter, the rate was to be increased by $0.01 per MCF.

Alternative rates:

(a) Subsequent to the first ten years after the date of initial delivery into the pipeline to be constructed by Pacific, or after July 1, 1956, if earlier, the higher of the minimum rate specified above and ‘5 cents per MCF less than the arithmetic average of the three highest prices being paid at the well-head in * * * the San Juan Basin * * *, said average to be determined at the commencement of the five-year period beginning on the date ten years subsequent to the date of initial delivery of gas into Pacific's pipeline and at the commencement of each five-year period thereafter.’

(b) From and after 20 years from the date of initial delivery into the pipeline or July 1, 1956, if earlier, the highest of the above two rates and ‘75% of the arithmetic average of the three highest prices at the wellhead paid by pipe line operators in * * * the San Juan Basin * * * .’

The contract also included a ‘take-or-pay’ provision which required Pacific to pay Pan American according to the following formula regardless of the volume of gas actually produced:

Pacific shall at all times take, or failing to take, nevertheless make the payments required hereunder based upon volumes of gas attributed to the working interest heretofore conveyed by the aforesaid assignments at a daily rate, averaged over each calendar year, equal to the greatest volume determinable under any of the following three conditions:

(a) 19% of the calculated open flow capacity of each well * * *

(b) That fractional part of the allowable of each well situated on leases hereby assigned which is equal to the largest fractional part of the allowable taken by Pacific from any other well situated in the same field or unit * * *

(c) A quantity at least equal to the amount of gas taken from any well offsetting a well located on any of the acreage covered by leases subject hereto, provided that such well on said lease acreage is capable of producing at least as much gas as such offsetting well against the same or greater back pressure.

the Contract did not specify whether payments made pursuant to the foregoing formula could be applied against subsequent production from the properties.

At the time the contracts were signed, Pacific lacked the financial resources out of which it could have made the payments due under the contracts in respect of the gas to be produced. Pan American looked primarily to gas production from the Pacific formations as the source of the payments, and to secure the payments, it retained a prior lien on all oil and gas production from the Pacific formations.

Although both parties contemplated that the Pacific formations would produce gas only, they included in the contracts a number of provisions which reserved to Pan American substantial rights in any oil which might be produced. Pacific was required to pay to Pan American, either in kind or by cash payment, an overriding royalty of 82 1/2 percent of the ‘oil’ produced and saved from each ‘oil well' on the leased properties in excess of 15 barrels of oil per day per oil well. Pan American also had the option of requiring Pacific to retransfer to it any oil well drilled on the leased premises, together with the appropriate acreage, in return for a payment reimbursing Pacific for its drilling and operating expenses. However, if Pan American subsequently completed a ‘gas well' on the acreage so assigned, it, under certain conditions, had the option to reassign the well to Pacific in return for a payment compensating it for its drilling and operating expenses. Pacific was also required to pay Pan American for the ‘oil content of the gas produced from a gas well * * * and separated from said gas (or capable of being separated from said gas) * * * in excess of eight (8) barrels per million cubic feet of gas' at the rate of ‘75% of the posted field price per barrel, or in the event there is no posted field price, 75% of the market value thereof.’ In addition, Pan American was granted ‘the option and exclusive right to purchase all oil produced and saved from the lease acreage * * * at the market price for production of similar kind and quality prevailing in the field where produced on date od delivery.’

The contracts defined ‘oil’ as ‘any liquid or liquefiable hydrocarbon having a gravity of fifty (50) or less degrees API, corrected to sixty (60) degrees Fahrenheit,‘ and ‘oil well’ as ‘any well which produces more than one (1) barrel of oil per one hundred (100) MCF of natural gas.’

The contracts defined ‘gas' as ‘natural gas including all liquefiable hydrocarbons which may be extracted or recovered therefrom, ‘ and ‘gas well’ as ‘any well which produces more than one hundred (100) MCF of natural gas per barrel of oil.

Subject to the provisions for reimbursement for costs incurred with respect to the oil wells which were reassigned to Pan American, Pacific was required to pay all the costs of exploration, development, and production of oil and gas from the Pacific formations and to pay all production, severance, and ad valorem taxes imposed as a result of such production. In addition, and subject to the provisions for release and reassignment of Pacific's oil and gas rights, the contracts also required Pacific to pay all rentals and minimum royalties due under the leases.

The contracts included the following provision regarding assignment:

ARTICLE XXII

The terms, covenants and conditions of this Sales Contract and Operating Agreement shall be binding upon, and shall inure to the benefit of, the parties hereto and their respective successors and assigns; and said terms, covenants and conditions shall be covenants running with the land and leasehold estates covered hereby and with each transfer or assignment of said land or leasehold estates; provided, however Pacific shall not be bound by any conveyance by (Pan American) * * * until thirty (30) days after Pacific shall have received a copy of the conveyance or other appropriate proof thereof. Pacific shall not assign its rights or any part thereof in the leases subject to this agreement or any of them to any third party without first notifying (Pan American) * * * in writing of the proposed transfer and receiving its consent thereto. (Pan American) * * * agrees to respond to said notification in writing within fifteen (15) days of its receipt thereof, failing which its consent will be presumed.

A transfer by Pacific made under and pursuant to the provisions of any mortgage or deed of trust to which the land and leasehold estates covered hereby may hereafter be subject shall not be deemed to be a transfer hereunder requiring the consent of * * * (Pan American); provided such transfer shall at all times be subject to the terms and provisions of this Sales Contract and Operating Agreement.

Between the time when the original eight contracts were executed and the end of 1957, the contracts were modified at least nine times by a series of letter agreements. Some of the agreements applied to all eight contracts; others applied only to the six contracts here in issue; and several applied only to individual contracts. The letter agreements clarified and/or relaxed Pacific's drilling, obligations, required Pan American, under certain circumstances, to reimburse Pacific for certain expenses incurred with respect to leases which were reassigned to Pan American, and made other minor modifications in the contracts for the convenience of Pacific in its drilling operations and in making payments under the assigned leases.

James C. Conner negotiated the original eight contracts on behalf of Pan American. At the time the contracts were executed, it had been his belief that Pan American was ‘selling * * * real estate’ to Pacific and that Pan American would consequently be taxed on the ‘sales' proceeds at favorable capital gain rates. Some time later, Conner learned that Pan American's accounting department had not treated the transactions as sales and was reporting the proceeds as ordinary income for Federal income tax purposes. Upon inquiry he was advised that in order to qualify for capital gain treatment, Pan American would have to place an upper limit on the amount which Pacific was required to pay for the properties and that the limit would have to be reached before the properties were exhausted.

Conner contacted Pacific to negotiate the necessary modifications in the contracts. At that time Pacific was also interested in modifying several other provisions in the contracts. It desired a relaxation of its drilling obligations and modification of the provisions requiring Pan American's consent to any assignment of Pacific's rights under the contracts. Pacific was interested in the latter change because it was then considering the sale of its rights under the contracts to Pacific Northwest Production Corp. (Pacific Production), its subsidiary, and because of the possibility of a merger with El Paso's Natural Gas Co. (El Paso), which, by the spring of 1957, had acquired 98.2 percent of Pacific's capital stock. Since antitrust proceedings had already been filed against El Paso on account of its extensive holdings of Pacific stock, it was likely that the merger would also be attacked.

By the spring of 1957, El Paso had acquired, at least in part through a public tender offer, practically all of Pacific's stock. In July 1957, antitrust proceedings were filed against El Paso for alleged violation of sec. 7 of the Clayton Act. On Aug. 7, 1957, El Paso applied to the FPC for permission to acquire the assets of Pacific and on the same date Pacific filed an application with the FPC to abandon its assets in favor of El Paso. The Commission authorized the merger on Dec. 23, 1959 (22 F.P.C. 1091, 23 F.P.C. 350), and on Dec. 31, 1959, Pacific was merged into El Paso.
The merger stimulated a consideration amount of litigation, culminating in four separate U.S. Supreme Court decisions between 1962 and 1969. In 1962 the Court held that the FPC should have awaited the outcome of the antitrust suit before authorizing the merger. California v. FPC, 369 U.S. 482. In 1964 the Court held that El Paso had violated sec. 7 of the Clayton Act by acquiring the stock and assets of Pacific and ordered an immediate divestiture of the assets acquired from Pacific. United States v. El Paso Gas Co., 376 U.S. 651. Two subsequent decisions, in 1967 and 1969, rejected divestiture proposals which had received lower court approval and ordered a cash sale of Pacific's assets. Cascade Nat. Gas v. El Paso Natural Gas, 386 U.S. 129; Utah Comm'n. v. El Paso Gas Co., 395 U.S 464.

As a result of the subsequent negotiations, Pan American and Pacific executed six ‘Modification Agreements,‘ dated as of January 1, 1958. The agreements made the following principal changes in the six contracts now under consideration.

(a) Pacific's payments based on gas production were to be limited to the following amounts:

+------------------------------------------------------+ ¦ ¦No. of ¦ ¦ +-------------------------------+----------+-----------¦ ¦ ¦contract ¦Amount ¦ +-------------------------------+----------+-----------¦ ¦Area ¦amended ¦specified ¦ +-------------------------------+----------+-----------¦ ¦ ¦ ¦ ¦ +-------------------------------+----------+-----------¦ ¦Bondad ¦27836 ¦$28,775,500¦ +-------------------------------+----------+-----------¦ ¦Township Units ¦27834 ¦54,063,800 ¦ +-------------------------------+----------+-----------¦ ¦Rosa Unit ¦27833 ¦8,098,600 ¦ +-------------------------------+----------+-----------¦ ¦Ignacio ¦27832 ¦30,662,300 ¦ +-------------------------------+----------+-----------¦ ¦N. W. Cedar Hill (South Bondad)¦27831 ¦12,388,500 ¦ +-------------------------------+----------+-----------¦ ¦Huerfano ¦27829 ¦630,300 ¦ +-------------------------------+----------+-----------¦ ¦ ¦ ¦ ¦ +-------------------------------+----------+-----------¦ ¦ ¦ ¦ ¦ +-------------------------------+----------+-----------¦ ¦Total ¦ ¦134,619,000¦ +------------------------------------------------------+

(b) Pacific was permitted to transfer its contract rights without Pan American's consent, subject, however, to Pan American's lien on production. In the event of such transfer, Pan American was entitled to 50 percent of the sale price, and that amount was to be applied to reduce the consideration then owed by Pacific. However, Pacific was not required to pay Pan American any portion of the consideration it received

for any assignment made * * * pursuant to the provisions of any mortgage or deed of trust in effect as of the date of execution hereof, or for any assignment made as part of any corporate reorganization, merger, or for any assignment made to a parent or subsidiary corporation of Pacific.

(c) Pacific's drilling and development obligations were clarified and relaxed.

(d) The Modification Agreements would ‘inure to the benefit of and be binding upon the parties hereto, their respective successors and assigns, should any assignment be made * * * as part of any corporate reorganization or merger, or should any assignment be made to a parent or subsidiary corporation of Pacific.’

By a letter agreement, dated April 11, 1958, Pan American and Pacific amended the Modification Agreements. They provided, in part, that Pacific would continue to be obligated under each of the original six contracts until the aggregate consideration of $134,619,000 was paid:

Pacific shall continue to be obligated for further consideration and payments to Pan American, its successors and assigns, based upon production of gas as required under the provisions of * * * those certain six Sales Contracts and Operating Agreements until the total sum of One Hundred Thirty-four Million, Six Hundred Nineteen Thousand Dollars ($134,619,000.00) has been paid to Pan American, its successors and assigns, and upon final payment of said total sum of money Pacific shall not be obligated for any further consideration to Pan American based upon production of gas * * *

The lien provision contained in * * * each of those certain six Sales Contracts and Operating Agreements shall be perpetuated and remain in full force and effect as to all of the properties subject to said Sales Contract * * * until final payment of the total consideration * * *

Subsequently, on December 31, 1959, Pacific merged into El Paso, and El Paso thereby acquired all of Pacific's rights in the six contracts as amended and modified. In 1965, by letter agreement, El Paso and Pan American declared their understanding of the Modification Agreements to be that after the total consideration of $134,619,000 had been paid, El Paso would be required to make no further payments to Pan American based on gas production or the oil content of gas produced, but that the obligation to pay the overriding oil royalties, as provided by the original contracts, would continue.

The total consideration of $134,619,000 was established on the basis of production and revenue figures from the assigned property through September 30, 1957, and on the basis of estimated production and revenue thereafter as follows:

+-------------------------------------------+ ¦Period ¦ +-------------------------------------------¦ ¦Payments through Sept. 30, 1957¦$763,489.76¦ +-------------------------------------------+

Estimated revenue Sept. 30, 1957, through Dec. 31, 1957 180,120.00 Estimated revenue after Jan. 1, 1958 133,675,480.00 Total 134,619,089.76

In setting the total consideration, Conner took into account reserve and production estimates (hereinafter found to be excessive) which had been submitted by Pacific to the FPC in 1957 and estimates of future market prices for San Juan Basin gas compiled by Pan American's own employees. On the basis of these estimates, Conner calculated that the payout of $133,675,480 in future years would require gas production until 1990, and that Pacific would retain approximately 800,000 MMCF of gas after it had paid Pan American the total consideration of $134,619,000.

Since Pacific's estimates of annual gas production forecast production only until 1976, the projected revenue for the years between 1976 and 1990 was based upon the assumption that the production projected for the year 1976 would continue for the following 14 years.

The price estimates, necessary to predict the effects of the contracts' alternative rate provisions (which took effect in 1966) were prepared in 1957 by Clute Jensen, Pan American's chief economist. His forecasts were based upon an assumed ‘going price’ of $0.15 per MCF on January 1, 1958 (substantially in excess of the $0.07 or $0.08 price then in effect under the contracts which had been negotiated only some 2 years earlier), and an estimated rate of increase in the price of gas of 2 percent per year thereafter. Gas prices did not continue to increase after 1960, however, partly as a result of a change in FPC policy at that time, and actual prices since that time have been substantially below those forecast by Jensen.

The reserve estimates available to Pan American and Pacific at the time they entered into the Modification Agreements were compiled as follows. In 1956, Pacific instituted proceedings (at times referred to as the Beatrice proceedings) before the FPC to obtain authority to construct and operate additional facilities in order to deliver 117,500 MCF of gas per day, about one-sixth of its then current capacity, to the Colorado Interstate Gas Co. (Interstate). The gas was to be delivered by Interstate to the Natural Gas Pipeline Co. of America at Beatrice, Nebr., and was to be marketed ultimately in the Chicago area. In order to gain FPC approval Pacific had to demonstrate that it had an adequate gas supply to fulfill its obligations in the project. In this connection, Pacific submitted to the FPC two estimates of natural gas reserves in the San Juan Basin, one dated April 29, 1957, covering the entire Basin, and a somewhat earlier one dated March 20, 1957, covering only Pacific's holdings in the Basin, including those acquired from Pan American. The estimates reflected an estimate of reserves in the property acquired from Pan American amounting to 1,838,973 MMCF. Such estimate was excessive, although data could be marshalled to support it. Pacific also submitted a schedule reporting estimates of the annual availability of gas from the San Juan Basin from 1958 through 1976. The schedule reflected and estimate of 607,091.9 MMCF of available gas for that period from the Pacific formations:

+------------------------------------------+ ¦ ¦ ¦Pan American's ¦ +------+------------------+----------------¦ ¦ ¦Total production ¦7/8 interest ¦ +------+------------------+----------------¦ ¦Year ¦MMCF/Yr. ¦MMCF/Yr. ¦ +------+------------------+----------------¦ ¦ ¦ ¦ ¦ +------+------------------+----------------¦ ¦1958 ¦19,649.7 ¦17,193.5 ¦ +------+------------------+----------------¦ ¦1959 ¦22,799.3 ¦19,949.4 ¦ +------+------------------+----------------¦ ¦1960 ¦26,070.8 ¦22,812.0 ¦ +------+------------------+----------------¦ ¦1961 ¦28,253.4 ¦24,721.7 ¦ +------+------------------+----------------¦ ¦1962 ¦31,215.9 ¦27,313.9 ¦ +------+------------------+----------------¦ ¦1963 ¦35,556.1 ¦31,111.6 ¦ +------+------------------+----------------¦ ¦1964 ¦35,792.4 ¦31,318.4 ¦ +------+------------------+----------------¦ ¦1965 ¦35,847.2 ¦31,366.3 ¦ +------+------------------+----------------¦ ¦1966 ¦35,880.6 ¦31,395.5 ¦ +------+------------------+----------------¦ ¦1967 ¦35,732.0 ¦31,265.5 ¦ +------+------------------+----------------¦ ¦1968 ¦35,675.8 ¦31,216.3 ¦ +------+------------------+----------------¦ ¦1969 ¦35,619.7 ¦31,167.2 ¦ +------+------------------+----------------¦ ¦1970 ¦34,037.6 ¦29,782.9 ¦ +------+------------------+----------------¦ ¦1971 ¦33,788.1 ¦29,564.6 ¦ +------+------------------+----------------¦ ¦1972 ¦31,651.3 ¦27,694.9 ¦ +------+------------------+----------------¦ ¦1973 ¦31,573.9 ¦27,627.2 ¦ +------+------------------+----------------¦ ¦1974 ¦32,648.5 ¦28,567.4 ¦ +------+------------------+----------------¦ ¦1975 ¦32,901.1 ¦28,788.5 ¦ +------+------------------+----------------¦ ¦1976 ¦32,398.5 ¦28,348.7 ¦ +------+------------------+----------------¦ ¦ ¦ ¦ ¦ +------+------------------+----------------¦ ¦ ¦ ¦ ¦ +------+------------------+----------------¦ ¦ ¦607,091.9 ¦531,205.5 ¦ +------------------------------------------+

The estimates were prepared by or under the supervision of Val Reese, Pacific's chief geologist.

At the time he made the foregoing estimates, Reese concluded that there was very little chance that the properties assigned to Pacific by Pan American would produce any oil, as that term was defined by the six contracts.

In connection with its tender offer for Pacific's stock made in July 1957, El Paso filed an estimate of Pacific's total reserves in the San Juan Basin with the Securities and Exchange Commission as part of its prospectus. The estimate was prepared by the firm of Brokaw, Dixon, and McKee, an outside consultant employed by El Paso, and it forecast that Pacific's total gas reserves (including reserves from sources other than Pan American as well as from Pan American sources) amounted to 4,806,000 MMCF. It was in El Paso's interest to acquire Pacific's stock as reasonably as it could, and this was a conservative but reasonable estimate as of that time. The portion of the estimate allocable to the reserves acquired from Pan American was substantially below the 1,838,973 MMCF estimate allocable to such reserves in the estimates submitted by Pacific in the ‘Beatrice’ proceedings.

In its application, filed with the FPC on August 7, 1957, for permission to merge with Pacific, El Paso incorporated by reference certain exhibits which had been filed in the ‘Beatrice’ proceedings showing Pacific's estimates of its gas supply. These estimates (which reflected reserves from Pan American sources amounting to 1,838,973 MMCF) were substantially higher than the El Paso estimates submitted to the Securities and Exchange Commission, and were used by El Paso in its application to the FPC because the ‘Beatrice’ proceedings were then still pending before the FPC. However, El Paso never agreed to the ‘Beatrice’ proceedings estimates, and the FPC staff did not accept them. Accordingly, El Paso thereafter (in early 1958) filed with the FPC a supplement containing an estimate of approximately 4,600,000 MMCF of gas as Pacific's total reserves in the San Juan Basin as of January 1, 1957. That figure included estimated reserves of 1,037,757 MMCF for the acreage which Pacific had acquired from Pan American and estimated total production from those reserves of 411,099.5 MMCF through 1976. The estimates were prepared by or under the direction of A. M. Derrick, an El Paso employee, who brought prior El Paso estimates of the reserves in the San Juan Basin up to date as of the end of 1956. It subsequently became apparent in 1960, as hereinafter set forth, that the 1,037,757 MMCF estimate was too high. However, the estimate that reflected that figure was reasonable as of the time it was made.

In 1960, about 2 years after Pacific and Pan American had entered into the Modification Agreements, Derrick found that pressure performance data from the San Juan Basin wells, the data ordinarily used for reserve estimates after the field in question has produced, would not support the volumetric or pore volume estimate which El Paso had previously submitted to the FPC in 1958. Although there was still insufficient pressure performance data for a complete study, Derrick concluded that the volumetric estimate for two formations, the Mesa Verde and the Pictured Cliffs, should be reduced by 30 percent and 45 percent respectively. As a result, in its annual report to the FPC in 1960, El Paso reduced its estimated reserves for those formations accordingly. A corresponding reduction in the previous estimate of 1,037,757 MMCF for the property acquired from Pan American would have produced an estimate of approximately 753,000 MMCF. Further experience derived from actual production data by 1963 substantially confirmed the foregoing downward revisions and the FPC staff in 1963 agreed with the basis for such revised estimates.

Prior to January 1, 1958, Pacific reassigned to Pan American a total of 58,519.41 ‘gross acres' and 30,409.26 ‘net acres.' The contract areas involved were as follows:

‘Gross acres' are the total acres covered by the six original contracts and include acres leased both exclusively and nonexclusively to Pan American (or Stanolind).

‘Net acres' are the sum of (1) the gross acres leased exclusively to Pan American (or Stanolind), plus (2) the proportionate interest, expressed by the appropriate number of acres, held by Pan American (or Stanolind) in gross acres under other leases.

+-----------------------------------+ ¦ ¦Gross ¦Net ¦ +---------------+---------+---------¦ ¦Contract area ¦acres ¦acres ¦ +---------------+---------+---------¦ ¦ ¦ ¦ ¦ +---------------+---------+---------¦ ¦Ignacio ¦2,410 ¦2,410 ¦ +---------------+---------+---------¦ ¦Rosa Unit ¦23,554.05¦11,777.03¦ +---------------+---------+---------¦ ¦Township units:¦ ¦ ¦ +---------------+---------+---------¦ ¦N.E. Area ¦1,683.81 ¦1,683.81 ¦ +---------------+---------+---------¦ ¦N.W. Area ¦480 ¦480 ¦ +---------------+---------+---------¦ ¦Huerfano ¦30,391.55¦14,058.42¦ +---------------+---------+---------¦ ¦ ¦58,519.41¦30,409.26¦ +-----------------------------------+

The reassigned acreage was largely outside the productive limits determined by Pacific for purposes of the estimate it presented to the FPC.

Subsequent to January 1, 1958, Pacific reassigned to Pan American a total of 42,185.98 gross acres and 33,305.37 net acres. The contract areas involved were as follows:

+-----------------------------------------+ ¦Contract area ¦Gross acres ¦Net acres ¦ +---------------+-------------+-----------¦ ¦ ¦ ¦ ¦ +---------------+-------------+-----------¦ ¦Bondad ¦8,599.89 ¦8,599.89 ¦ +---------------+-------------+-----------¦ ¦N.W. Cedar Hill¦2,960.20 ¦2,960.20 ¦ +---------------+-------------+-----------¦ ¦Ignacio ¦5,716 ¦5,716 ¦ +---------------+-------------+-----------¦ ¦Rosa Unit ¦13,024.91 ¦6,552.45 ¦ +---------------+-------------+-----------¦ ¦Township Units:¦ ¦ ¦ +---------------+-------------+-----------¦ ¦N.E. Area ¦7,116.82 ¦7,116.82 ¦ +---------------+-------------+-----------¦ ¦N.W. Area ¦80 ¦80 ¦ +---------------+-------------+-----------¦ ¦S.E. Area ¦731.57 ¦731.57 ¦ +---------------+-------------+-----------¦ ¦Huerfano ¦3,956.59 ¦1,548.44 ¦ +---------------+-------------+-----------¦ ¦Totals ¦42,185.98 ¦33,305.37 ¦ +-----------------------------------------+

Between March 16, 1955, and January 1, 1958, a total of 114 wells were drilled on the acreage subject to the six contracts; of these, 103 were productive and 11 were nonproductive. All 11 nonproductive wells were either outside or near the borders of the area considered productive by the estimate which Pacific had submitted to the FPC in 1957. Ninety-one wells were drilled subsequent to January 1, 1958; 85 were productive and 6 were nonproductive. The 6 nonproductive wells were either outside or near the borders of the areas considered productive by Pacific's estimate. Twenty-nine of the 85 productive wells were drilled by Pan American (or by third parties under contracts with Pan American) on reassigned acreage.

Pan American's books and tax returns reflected receipts through 1968 in respect to the payments based on gas production as follows:

+--------------------+ ¦Year ¦Amount ¦ +------+-------------¦ ¦ ¦ ¦ +------+-------------¦ ¦1955 ¦$3,650.86 ¦ +------+-------------¦ ¦1956 ¦151,451.01 ¦ +------+-------------¦ ¦1957 ¦778,429.57 ¦ +------+-------------¦ ¦1958 ¦597,596.49 ¦ +------+-------------¦ ¦1959 ¦606,122.22 ¦ +------+-------------¦ ¦1960 ¦671,130.10 ¦ +------+-------------¦ ¦1961 ¦805,235.36 ¦ +------+-------------¦ ¦1962 ¦754,263.24 ¦ +------+-------------¦ ¦1963 ¦797,201.04 ¦ +------+-------------¦ ¦1964 ¦850,039.85 ¦ +------+-------------¦ ¦1965 ¦876,837.39 ¦ +------+-------------¦ ¦1966 ¦926,783.16 ¦ +------+-------------¦ ¦1967 ¦895,530.98 ¦ +------+-------------¦ ¦1968 ¦934,490.52 ¦ +------+-------------¦ ¦ ¦9,648,761.79 ¦ +--------------------+

The amounts paid to Pan American and the annual gas production which served as the basis for those payments, as computed by Pacific and El Paso, were as follows:

+----------------------------------+ ¦ ¦MCF of gas ¦Amount paid ¦ +------+------------+--------------¦ ¦Year ¦produced ¦Pan American ¦ +------+------------+--------------¦ ¦ ¦ ¦ ¦ +------+------------+--------------¦ ¦1955 ¦46,898 ¦$3,282.86 ¦ +------+------------+--------------¦ ¦1956 ¦3,902,504 ¦273,175.27 ¦ +------+------------+--------------¦ ¦1957 ¦9,283,220 ¦649,825.34 ¦ +------+------------+--------------¦ ¦1958 ¦8,310,628 ¦618,119.84 ¦ +------+------------+--------------¦ ¦1959 ¦7,721,645 ¦620,432.38 ¦ +------+------------+--------------¦ ¦1960 ¦8,342,204 ¦667,357.18 ¦ +------+------------+--------------¦ ¦1961 ¦9,912,704 ¦793,216.12 ¦ +------+------------+--------------¦ ¦1962 ¦9,077,557 ¦726,204.56 ¦ +------+------------+--------------¦ ¦1963 ¦10,188,543 ¦831,406.16 ¦ +------+------------+--------------¦ ¦1964 ¦10,641,980 ¦851,584.35 ¦ +------+------------+--------------¦ ¦1965 ¦11,006,374 ¦880,509.92 ¦ +------+------------+--------------¦ ¦1966 ¦10,697,263 ¦905,953.31 ¦ +------+------------+--------------¦ ¦1967 ¦9,378,530 ¦886,317.80 ¦ +------+------------+--------------¦ ¦1968 ¦9,444,112 ¦941,935.94 ¦ +------+------------+--------------¦ ¦Total ¦117,954,162 ¦9,649,321.03 ¦ +----------------------------------+

The actual volume of gas production between 1958 and 1968 was far below that estimated by Pacific in 1957.

Although the matter was not free from doubt, a reasonable estimates could have been made as of January 1, 1958, that Pacific would have been left with some obligation-free reserves after it had paid Pan American the total consideration of $134,619,000. In view of the variables involved, it is not possible to make a reliable determination as to the precise number of years required to pay the total consideration of $134,619,000, but a reasonable estimate as of January 1, 1958, of the period required to produce enough gas to pay that total consideration would have been between 50 and 100 years. On the basis of the revised estimates of the reserves made in 1960 there would not have been a sufficient supply of gas to pay the total stated consideration of $134,619,000.

At the time of the trial herein, the properties assigned to Pacific had produced no ‘oil’ (as that term was defined in the contracts) and the oil content of the gas produced in the assigned formations had never been sufficiently high to bring into effect the contract provisions governing payments with respect to such oil.

As of January 1, 1958, Pan American's adjusted basis with respect to the leases covered by the six contracts was $509,095.19. Standard's consolidated income tax returns for the years 1958 and 1959 reported as proceeds of sale on the installment basis the amounts of $597,596.49 and $606,122.22 received by Pan American pursuant to the contracts as payments based on gas production, and reflected with respect thereto the amounts of $595,320.75 and $603,814.01 as capital gains realized on the sale of property used in Pan American's trade of business.

In his deficiency notice to Standard and its affiliates the Commissioner, in addition to other adjustments which are no longer in issue, determined that the payments received by Pan American were ordinary income rather than capital gain.

OPINION

RAUM, Judge:

The dispute between petitioner and the Commissioner centers on whether during the years in issue Pan American retained an ‘economic interest’ in the properties transferred to Pacific. The parties appear to agree that if Pan American retained an economic interest in the properties, Pan American's receipts in 1958 and 1959 represent ordinary income to it, subject to depletion, but that if it retained no such interest, the receipts reflect capital gain realized by Pan American on the sale of Property used in its trade or business.

The petitioner contends that as of January 1, 1958, Pan American did not look solely to the extraction of gas from the assigned properties for payment of the total consideration of $134,619,000, and that therefore, according to Anderson v. Helvering, 310 U.S. 404, it did not retain an ‘economic interest’ in the properties. The Commissioner's response is twofold. First, he argues that in fact Pan American did look solely to the assigned properties' gas production as the source of the deferred payments. Secondly, he contends that even if the properties' gas production were not the sole source of payments, the facts of this case are distinguishable from those of Anderson v. Helvering, supra, in that here the total consideration of $134,619,000 was far in excess of any amount Pan American could reasonably have expected to derive from contracts and that by setting such a large amount as the total consideration, Pan American reserved to itself a permanent interest in the assigned properties and thus did not dispose of them by sale.

Because we agree with the Commissioner's first contention and although much of the parties' efforts at the trial herein attempted to establish the amount of revenue which Pan American could reasonably have expected to receive under the contracts, we find it unnecessary to consider the Commissioner's second argument.

The concept of ‘economic interest’ is generally regarded as having been introduced in 1933 in Palmer v. Bender, 287 U.S. 551. In that case, the taxpayer was a member of two partnerships. Each partnership had acquired oil and gas leases and assigned part of the leased properties to a third party in consideration of a present payment of a cash bonus, a future payment to be paid ‘out of one-half of the first oil produced and saved’ to the extent of a named sum, and an additional ‘excess royalty’ of one-eighth of all the oil produced and saved. The taxpayer claimed that all three types of payments were taxable to him as ordinary income subject to depletion, while the Government contended that the assignments were sales and that the only allowable deduction was the cost of the properties. In holding for the taxpayer, the Supreme Court declared (287 U.S. at 557):

the lessor's right to a depletion allowance does not depend upon his retention of ownership or any other particular form of legal interest in the mineral content of the land. It is enough, if, by virtue of the leasing transaction, he has retained a right to share in the oil produced. If so he has an economic interest in the oil, in place, which is depleted by production.

A taxpayer, the Court announced, has an economic interest in every case where he ‘has acquired, by investment, any interest in the oil in place, and secures, by any form of legal relationship, income derived from the extraction of oil, to which he must look for a return of his capital.’ 287 U.S.at 557.

Four years later, in Thomas v. Perkins, 301 U.S. 655, the Court considered the tax consequences of a similar transaction upon an assignee of certain oil and gas leases. In that case, the assignment instrument recited that the assignors (301 U.S. at 657)

in consideration of the sum of Ten Dollars ($10.00) cash1 * * * and of the further sum of Three Hundred Ninety Five Thousand Dollars ($395,000.00) to be paid out of the oil produced and saved from the * * * lands, and to be one-fourth of all the oil produced and saved * * * until the full sum * * * is paid, * * * do hereby bargain, sell, transfer, assign, and convey all our rights, title, and interest in and to said leases and rights thereunder.

/1/ Contemporaneously with the assignment there was paid $105,000 in cash and $50,000 in notes.

After describing the assigned properties, the instrument further provided that the $395,000 payment (301 U.S. at 657)

is payable out of oil only, if, as and when produced from said lands above described, and said oil payment does not constitute and shall not be a personal obligation of the assignee, its successors or assigns.

The assignee did not include in taxable income any part of the proceeds from the sale of oil which were paid over to the assignors. In upholding the assignee's position, the Court found that as in Palmer v. Bender, supra, the assignors had retained an economic interest in the assigned leases and that the income from that interest was therefore chargeable to the assignors and subject to depletion. The Court declared (301 U.S.at 659):

The provisions for payment to assignors in oil only, the absence of any obligation of the assignee to pay in oil or in money, and the failure of assignors to take any security by way of lien or otherwise unmistakably show that they intended to withhold from the operation of the grant one-fourth of the oil to be produced and saved up to an amount sufficient when sold to yield $395,000.3 (Footnote omitted.)

In Anderson v. Helvering, 310 U.S. 404, the Court limited the ‘economic interest’ doctrine developed in Palmer v. Bender and 1115 Thomas v. Perkins. There several taxpayers were assigned ‘certain royalty interests, fee interests, and deferred oil payments in properties in Oklahoma’ in return for (310 U.S.at 405-406)

the agreed consideration of one hundred sixty thousand dollars, payable fifty thousand in cash and one hundred ten thousand from one-half of the proceeds received by him which might be derived from oil and gas produced from the properties and from the sale of fee title to any or all of the land conveyed. Interest at the rate of 6% per annum was to be paid from the proceeds of production and of sales upon the unpaid balance.

During the first year under the arrangement, the gross proceeds derived from the production and sale of oil and gas from the assigned properties amounted to approximately $55,000, and during the second year, the year in issue in Anderson, the gross proceeds amounted to more than $81,000. One-half of each sum was distributed to the assignor pursuant to the assignment agreement. The assignee-taxpayers then claimed that the amount paid over to the assignor in the year in issue should not be included in their income, relying upon Thomas v. Perkins. The Supreme Court rejected their claim, holding that the transaction should be treated as a sale to the taxpayers, that the sum paid to the assignor was part of the sale price, and that consequently the taxpayers were taxable on the gross proceeds derived from oil production. The Court distinguished Thomas v. Perkins as follows (310 U.S.at 412-413):

The opinion of the Supreme Court did not mention the amount of the proceeds during the first year, but such a finding was made by the Board of Tax Appeals (7 P-H.B.T.A.Memo 38-492, 38-493) and was included in the opinion of the Court of Appeals (107 F.2d 459, 460 (C.A. 10)).

The reservation of an interest in the fee, in addition to the interest in the oil production * * * materially affects the transaction. Oklahoma Company is not dependent entirely upon the production of oil for the deferred payments; they may be derived from sales of the fee title to the land conveyed. It is clear the payments derived from such sales would not be subject to an allowance for depletion of the oil reserves, for no oil would thereby have been severed from the ground; all allowance for depletion upon the proceeds of such a sale would result, contrary to the purpose of Congress, in a double deduction—first, to Oklahoma Company; second, to the vendee-owner upon the production of oil. Helvering v. Twin Bell Oil Syndicate, 293 U.S. 312, 321. We are of opinion that the reservation of this additional type of security for the deferred payments serves to distinguish this case from Thomas v. Perkins. It is similar to the reservation in a lease of oil payment rights together with a personal guarantee by the lessee that such payments shall at all events equal the specified sum. In either case, it is true, some of the payments received may come directly out of the oil produced. But our decision in Thomas v. Perkins does not require that payments reserved to the transferor of oil properties shall for tax purposes be treated distributively, and not as a whole, depending upon the source from which each dollar is derived. An extension of that decision to cover the case at bar would create additional, and in our opinion unnecessary, difficulties to the allocation for income tax purposes of such payments and of the allowance for depletion between transferor and transferee. In the interests of a workable rule, Thomas v. Perkins must not be extended beyond the situation in which, as a matter of substance, without regard to formalities of conveyancing, the reserved payments are to be derived solely from the production of oil and gas. The deferred payments reserved by Oklahoma Company, accordingly, must be treated as payments received upon a sale to petitioners, not as income derived from the consumption of its capital investment in the reserves through severance of oil and gas.

Petitioners, as purchasers and owners of the properties, are therefore taxable upon the gross proceeds derived from the oil production, notwithstanding the arrangement to pay over such proceeds to Oklahoma Company. See Helvering v. Clifford, 309 U.S. 331; Reinecke v. Smith, 289 U.S. 172, 177; Old Colony Trust Co. v. Commissioner, 279 U.S. 716.

Relying on Anderson v. Helvering, petitioner herein contends that as of January 1, 1958, Pan American did not look solely to the extraction of oil or gas for payment of the aggregate amount of $134,619,000, that consequently Pan American did not retain an economic interest in the natural gas in the formations, and that therefore the payments to Pan American during 1958 and 1959 are taxable to it as capital gain realized on the sale of property used in its trade or business. In particular, the petitioner points to the ‘take-or-pay’ provisions in the original contracts, which assured Pan American of minimum annual payments, and to the 1958 Modification Agreements, which permitted Pacific to transfer its interest in the assigned properties and reserved to Pan American one-half of the proceeds from such a sale, and urges that, as of January 1, 1958, gas production from the Pacific formations was not the sole security for the deferred payments and that consequently this case is governed by Anderson v. Helvering. We disagree.

Anderson decided that since the transferor of the mineral properties there in question did not look solely to the properties' subsequent mineral production as the source of the transferees' payments, the payments should not be eliminated from the transferees' gross income; and by inference it may be concluded that such payments were to be treated in the hands of the transferor as the proceeds of sale rather than royalties or the like. But in announcing its decision the Court clearly stated that it was not establishing a rigid rule to be applied in every case regardless of the substance of the transaction under consideration. It declared (310 U.S.at 413):

However, since gross income thus remained undiminished by reason of these payments, depletion deductions would be allowable to the transferees in respect of the entire gross income.

In the interests of a workable rule, Thomas v. Perkins must not be extended beyond the situation in which, as a matter of substance, without regard to formalities of conveyancing, the reserved payments are to be derived solely from the production of oil and gas.

We think that in substance Pan American looked only to the gas production of the Pacific formations as the source of its deferred payments. In form the ‘take-or-pay’ provisions and the provisions in the Modification Agreements reserving to Pan American one-half of the proceeds from sales by Pacific appear to offer Pan American additional security for the deferred payments. However, closer examination reveals the purported security to be without practical significance.

We consider first the ‘take-or-pay’ provisions. In substance they established minimum royalties, and it has been held on a number of occasions that a minimum royalty, when coupled with a royalty based upon the quantity of mineral extracted, is not a sufficiently significant source of return to negate retention of an economic interest. See Wood v. United States, 377 F.2d 300, 307 (C.A. 5), certiorari denied 389 U.S. 977; Freund v. United States, 367 F.2d 776, 778 (C.A. 7); cf. Burnet v. Harmel, 287 U.S. 103, 111-112; Nassau Suffolk Lumber & Supply Corp., 53 T.C. 280, 284. Here the ‘take-or-pay’ formulas were geared to potential or possible gas production from the Pacific formation and would thus become effective only if Pacific chose to make payments to Pan American without extracting the gas available to it. In such circumstances, the ‘take-or-pay’ provisions would simply safeguard Pan American's interest in the gas when Pacific had decided against production. In addition, we think it not without significance that prior to 1958 Pan American treated the payments it received from Pacific as ordinary income— despite the fact that the ‘take-or-pay’ provisions were in the contracts at that time— and that Pan American considered it necessary to introduce new provisions in 1958 in order to justify treating the payments as capital gain.

The record is not sufficiently clear to support a finding as to how Pacific and El Paso have treated the deferred payments for Federal income tax purposes. However, although Pacific and El Paso are not parties to these proceedings, we note that their positions are antagonistic to that of Pan American, and that the position of the Government is in the nature of a stakeholder. A decision that Pan American did retain an economic interest in the assigned gas rights would imply that Pacific and El Paso may exclude from income that portion of the proceeds of gas production attributable to the deferred payments, while a decision that the payments are capital gain to Pan American would imply that the expenses of Pacific and El Paso are capital in nature and that no corresponding exclusion would be allowed to them.

The new provisions, relating to the sale of Pacific's interest in the assigned properties, were added to the agreement in 1958 specifically for the purpose of enabling Pan American to treat the deferred payments as capital gain. While it is well-established that a taxpayer may reduce his tax burden by means which the law permits, Gregory v. Helvering , 293 U.S. 465, 469, the fact that the 1958 modifications were tax-motivated does invite careful scrutiny of the substance of the arrangement. We conclude that the provisions in the Modification Agreements permitting Pacific to assign its rights under the contracts and granting to Pan American one-half of the resulting proceeds were of no practical consequence, and that in reality, even after the Modification Agreements were executed, Pan American continued to look only to the production of gas as the source of its deferred payments. When the Modification Agreements were executed, Pacific had already received authority from the FPC to construct and operate a pipeline from the four-corners area to the Canadian border, and consequently the formations' gas reserves were not readily available for sale. Of course, if, upon application, FPC had given its approval, Pacific might have subsequently sold its gas rights, and the purchaser would then have become responsible for the pipeline's gas supply. But the petitioner has failed to persuade us that, as of January 1, 1958, such a sale was a realistic possibility. The petitioner has contended that the proposed merger with El Paso and the possible sale of Pacific's contract rights to Pacific Production were two such possible sales. We disagree. The Modification Agreements specifically provided that Pan American was not entitled to a share of the proceeds from an assignment pursuant to a corporate reorganization or merger or from an assignment to a subsidiary of Pacific. Thus, the possibility of these two transactions offered Pan American absolutely no additional security for the deferred payments; even if one of the transactions had actually been consummated, Pan American would not have been entitled to any of the resulting proceeds.

In its opinion in Anderson, the Supreme Court did not purport to consider the likelihood that the assignee of the properties there in question would subsequently sell them. However, the opinion of the Board of Tax Appeals indicates that the taxpayer— who contended that the transaction not be treated as a sale— had offered no evidence to show that subsequent sales were not of practical importance and that he had therefore failed to sustain his burden of proof: ‘Sales of fees were involved. The seller retained a lien. How much of the gross receipts was from sales of fees, how much from oil and gas produced from fees, and how much from royalties on leases is not shown. The record does not justify any change in the Commissioner's determination relating to these items.’ 7 P-H.B.T.A.Memo. 38-492, 38-493.
Here the petitioner contends that the transaction now in question should be treated as a sale, and the burden of proof is upon it to show that a subsequent sale by Pacific was a realistic possibility as of Jan. 1, 1958.

The petitioner has also pointed to the possibility (which eventually became a reality) that the then-pending antitrust proceedings would culminate in a court order requiring El Paso to enter into a cash sale of Pacific's assets. However, the possibility that the merger with El Paso would be approved by the FPC, that the antitrust proceedings would declare the merger unlawful, and that the antitrust decree would require a cash sale of Pacific's assets, rather than the customary remedy of divestiture not thus restricted, was, as of January 1, 1958, so highly speculative that the possibility of such an extraordinary sequence of events did not offer Pan American significant security for the deferred payments. We therefore conclude that as a practical matter Pan American looked to the gas production of the Pacific formations as the sole source of the deferred payments.

We also note several features of this transaction, not emphasized by the parties, which further distinguish Anderson from this case and which give additional support to the conclusion that Pan American retained an economic interest in the Pacific formations. In Anderson, the assignees made a substantial cash downpayment in addition to the subsequent payments based on oil production, interest was required on the unpaid balance, and over 60 percent of the total amount to be paid out of the oil proceeds was paid during the first 2 years after the agreement was signed. Here, apart from Pacific's initial payment for Pan American's interest in lease equipment, facilities, and productive wells, Pacific made no downpayment whatever. As a result, Pan American in substance relied exclusively upon gas production from the Pacific formations for its return on the transaction; without such production (or at least the possibility of production ), it could not reasonably expect to receive any return at all. Moreover, there was no provision for interest on the unpaid balance of Pacific's payments. The substantial cash downpayment and the provision for interest in Anderson suggest that the consideration paid there was the purchase price of the assigned properties. The absence of those features here indicates that the amounts paid to Pan American were in the nature of a return on its continuing interest in the Pacific formations and that in reality it looked only to the gas production of those formations for its return. Cf. Bryant v. Commissioner, 399 F.2d 800, 805-806 (C.A. 5); Nassau Suffolk Lumber & Supply Corp., 53 T.C. 280, 283-284. Similarly, the large payments in the first 2 years in Anderson suggest that the assignor's interest in the oil production of the assigned properties would soon be extinguished and that his position was therefore akin to that of a seller, while the lengthy projected payout period here indicates a far more durable interest, albeit not necessarily a permanent one. Cf. Moberg v. Commissioner, 365 F.2d 337, 340 (C.A. 5); Bryant v. Commissioner, supra at 805-806; Nassau Suffolk Lumber & Supply Corp., 53 T.C.at 283-284; United States v. Morgan, 321 F.2d 781, 783-787 (C.A. 5).

The ‘take-or-pay’ provisions offered the possibility of payments even if there were no actual gas production. However, the relevant formulas were geared to potential gas production and were applicable only if Pacific chose not to produce gas available to it. In addition, under the Modification Agreements, Pan American was entitled to one-half of the proceeds of a sale by Pacific of any of its rights under the contracts. However, we have found that the possibility of such a sale was not, as of Jan. 1, 1958, of practical significance.

Together, the absence of a provision for interest and the uncertainty and duration of the probable payout period, make it plain that the total consideration of $134,619,000 was not an ordinary ‘sale’ price. We have found that as of January 1, 1958, a reasonable estimate of the time required to produce enough gas to pay the total amount due under the contracts would have been between 50 and 100 years. A projection so far into the future and involving two variables— the annual price of gas and the volume of annual gas production— by its very nature involves a substantial margin of error. But despite the fact that payment of the full $134,619,000 within a period of relatively brief duration would have been far more valuable to it than payment over a substantially longer period, Pan American required no interest on the unpaid balance. The absence of such a requirement, when the time of final payment was so uncertain and so far off, convinces us that the transaction in issue was not a sale for a fixed purchase price, but an arrangement permitting Pan American to retain an economic interest in the Pacific formations.

Furthermore, all of the contracts imposed rather stringent drilling obligations on Pacific and included provisions for reassignment of unprofitable properties to Pan American. Also, in conducting their affairs under the contracts, Pan American and Pacific clarified, modified, or amended the contracts on at least 12 separate occasions. The foregoing is more suggestive of a continuing business relationship and of Pan American's retention of an economic interest in the properties than it is of a sale. Cf. Edward W. Reid, 50 T.C. 33, 41.

Pan American also retained an overriding royalty of 82 1/2 percent of the oil produced and saved from each well on the leased properties in excess of 15 barrels of oil per day per oil well— an interest that would persist in perpetuity even after payment of the aggregate purchase price of $134,619,000. Pan American's retention of these oil rights alone may or may not suffice to constitute a retained economic interest with respect to the gas in the Pacific formations. But the overriding oil royalty does lend further support to the continuing nature of Pan American's interest in the properties.

The Commissioner has urged that simply by virtue of the rights it retained in the oil in the Pacific formations, Pan American retained an economic interest in all of the assigned properties. In response, petitioner contends that the oil and gas interests were entirely separate, and it relies primarily in this respect upon Edward J. Hudson, 11 T.C. 1042 (acq. in part and nonacq. in part 1949-1 C.B. 2, 5), affirmed 183 F.2d 180 (C.A. 5). That case held that the assignee of a one-half interest in ‘heavier hydrocarbons,‘ which were mixed in with unassigned natural gas deposits, had acquired a depletable interest in the ‘heavier hydrocarbons.’ We are by no means persuaded that Hudson controls the question presented here. Petitioner also relies upon Berry Oil Co. v. United States, 25 F.Supp. 97 (Ct.Cl.), certiorari denied 307 U.S. 634, and regs. sec. 1.614-1(a)(1) and (5)— Example (1), but these authorities relate to assignments of district geological layers or areas and are not governing here. However, in view of our disposition of the case, we need not consider this question.

We conclude that Pan American retained an economic interest in the gas in the Pacific formations and that the payments it received in 1958 and 1959 should therefore be treated as ordinary income.

Decision will be entered under Rule 50.